“Things Have Been Going Up For Too Long”

I have to believe that the Fed injected a large amount of liquidity into the financial system on Sunday evening. The 1.08% jump in the S&P 500, given the fundamental backdrop of economic, financial and geopolitical news should be driving the stock market relentlessly lower. The amount of Treasury debt outstanding spiked up $318 billion to $20.16 trillion. I’m sure the push up in stocks and the smashing of gold were both intentional as a means of leading the public to believe that there’s no problem with the Government’s debt going parabolic.

Blankfein made the above title comment in reference to all of the global markets at a business conference at the Handlesblatt business conference in Frankfurt, Germany on Wednesday. He also said, “When yields on corporate bonds are lower than dividends on stocks – that unnerves me.” In addition to Blankfein warning about stock and bond markets, Deutsche Bank’s CEO, John Cryan, warned that, “We are now seeing signs of bubbles in more and more parts of the capital market where we wouldn’t have expected them.”

It is rare, if not unprecedented, the CEO’s of the some of the largest and most corrupt banks in the world speak frankly about the financial markets. But these subtle expressions of concern are their way of setting up the ability to look back and say, “I told you so.” The analysis below is an excerpt from the latest issue of the Short Seller’s Journal. In that issue I present a retail stock short idea plus include my list of my top-10 short ideas. To learn more, click here: Short Seller’s Journal information.

In truth, it does not take a genius or an inside professional to see that the markets have bubbled up to unsustainable levels. One look at GS’ stock chart tells us why Blankfein is concerned (Deutsche Bank’s stock chart looks similar):

The graph above shows the relative performance of GS vs. the XLF financial ETF and the SPX. Over the last 5 years, GS stock has outperformed both the XLF and the SPX. But, as you can see, over the last 3 months GS stock not only has underperformed its peers and the broader stock market, but it has technically broken down. Since the 2009 market bottom, the financials have been one of the primary drivers of the bull market, especially the Too BIg To Fail banks. That’s because the TBTFs were the primary beneficiaries of the Fed’s QE.

The fact that the big bank stocks like GS and DB are breaking down reflects a breakdown in the financial system at large. DB was on the ropes 2016, when its stock dropped from a high $54 in 2014 to $12 by September. It was apparent to keen observers that Germany’s Central Bank, the Bundesbank, took measures to prevent DB from collapsing. Its stock traded back up to $21 by late January this year and closed Friday at $16, down 24% from its 2017 high-close.

This could well be a signal that the supportive effect of western Central Bank money printing is wearing off. But I also believe it reflects the smart money leaving the big Wall Street stocks ahead of the credit problems percolating, especially in commercial real estate, auto and credit card debt. The amount of derivatives outstanding has surpassed the amount outstanding the last time around in 2008, despite the promise that the Dodd-Frank legislation would prevent that build-up in derivatives from repeating. It’s quite possible that the financial damage inflicted by the two hurricanes will be the final trigger-point of the next crisis/collapse. That’s the possible message I see reflected in the relative performance of the financials, especially the big Wall Street banks.

This would explain why the XLF financials ETF has been lagging the broad stocks indices. It’s well below its 52-week high and was below its 200 dma until today’s “miracle bounce” in stocks.

Again, I believe the really smart money sniffs a derivatives problem coming. Too be sure, the double catastrophic hurricane hit, an extraordinarily low probability event, could well be the event that triggers a derivatives explosion. Derivatives are notoriously priced too low. This is done by throwing out the probability of extremely rare events from the derivative pricing models. Incorporating the probability of the extremely rare occurrences inflate the cost of derivatives beyond the affordability of most risk “sellers,” like insurance companies.

Let me explain. When an insurance company wants to lay off some of the risk of insuring against an event that would trigger a big pay-out, it buys risk-protection – or “sells” that risk – using derivatives from a counter-party – the “risk buyer” – willing to bet that the event triggering the payout will not occur. If the event does not occur, the counter-party (risk buyer) keeps the money paid to it to take on the risk. If the event is triggered, the counter-party is responsible for making an “insurance payment” to the insurance company in an amount that is pre-defined in the derivatives contract.

Unfortunately it is the extremely low probability events that cause the most financial damage (this is known as “tail risk” if you’ve seen reference to this). Wall Street knows this and, unfortunately, does not incorporate the truth cost – or expected value – of the rare event from occurring into the cost of the derivative. Wall Street plays the game of “let’s pretend this will never happen” because it makes huge fees from brokering these derivatives. When the rare event occurs, it causes the “risk buyer” to default because the cost of making the payout exceeds the “risk buyer’s” ability to honor the contract. This is why Long Term Capital blew up in 1998, it’s why Enron blew up, it’s why the 2008 de facto financial collapse occurred. We are unfortunately watching history repeat. This is the what occurred in the “The Big Short.” The hedge funds that bet against the subprime mortgages knew that the cost of buying those bets was extremely cheap relative the risk being wrong.

If the hurricanes do not trigger a financial crisis, the massive re-inflation of subprime debt – and the derivative bets associated with that – are back to the 2008 levels.

The optimism connected to the stock market is staggering. According to recent survey, 80% of Americans believe that stock prices will not be lower in the next 12 months. This is the highest level of optimism since the fall of 2007. The SPX topped out just as this metric hit its high-point. The only time this level of optimism was higher in the history of the survey was in early 2000.

It has to continue to go up! Any sustained period where the “market” goes down and the pension funds of this country are completely destroyed for good. The pension funds would then have to admit to insolvency. The lie and the illusion must go on at all cost, the truth has become the enemy of the state. The show will go on until the PTB’s hand is forced and an epic crash occurs in all paper “assets”. We wait and we watch.